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TOPIC 5. Fed Policy and Money Markets. Outline. What is Money? What affects the supply of money ? How the banking system works? What is the Fed and how does it work? What is a monetary policy? What does affect the demand of money ? Asset Portfolio Decision Quantitative Theory of Money

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TOPIC 5

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Outline • What is Money? • What affects the supply of money? • How the banking system works? • What is the Fed and how does it work? • What is a monetary policy? • What does affect the demand of money? • Asset Portfolio Decision • Quantitative Theory of Money • Equilibrium in the Money Market • The LM curve

Money • “Money” is the economic term for assets that are widely used and accepted as payment. • The forms of money have been very different: from shells to gold to cigarettes • (Eastern Europe and German Prisoners Of War camps) • Most prices are measured in units of money → understanding the role of money is important to understanding inflation. • Many economists believe that money also has an impact on real variables (mostly in the short run)

Three Functions of Money • Medium of exchange: Money permits trade of goods and services at lower cost (in terms of time and effort) • Barter is inefficient because it is difficult and time-consuming to find a trading partner. • Other benefit: allows specialization (and increases productivity) • Unit of account: Money is the basic unit for measuring economic value • Given that goods and services are mostly exchanged for money, it is natural to express economic value in terms of money • Caveat: In countries with volatile inflation, money is a poor unit of account because prices must be changed frequently. More stable units of account like dollars or gold are used even if transactions use local currency. • Store of Value: money is a way of storing wealth. • Other types of assets may pay higher returns, BUT money is also a medium of exchange.

Measures of Money • The distinction between monetary and non-monetary assets is controversial. • Example: MMMFs (money market mutual funds) are organizations that sell shares to the public and invest in short-term government and corporate debt. MMMFs pay low return and allow for checking (with fees)…Are they Money? • There are two main official measures of money stock, called monetary aggregates: • M1: the most narrow definition, includes mainly currencies and balances held in checking accounts. • M2: includes everything in M1 plus other “money like” components: saving deposits, small time deposits, MMMFs, MMDAs (money market deposit accounts), etc..

Money Supply • Money supply is the amount of money available in an economy • In modern economies, money supply is affected by: • Central Banks (the Federal Reserve System in the United States). The central bank is a government institution responsible for monetary policies within an economy. See readings 51, 52 • Depositary Institutions. Deposit Institutions are privately owned banks and thrift institutions that accept deposits from and make loans directly to the public. • The public. The public includes every person or firm (except banks) that holds money in currency or deposits (think of money in your pocket or money in your firms “petty cash” drawer).

The Banking System: An Introduction • Bank Assets and Liabilities: • Assets: Loans (TL) + Reserves (TR) • Liabilities: Deposits (TD) (and potentially other stuff). • Reserves = liquid assets held by the bank to meet the demand for • withdrawals by depositors or to pay checks • How do banks make money? They Lend. • How much do they lend? Must keep a minimum amount of reserves (required by law). • Definition: m = required reserve ratio

What is the Fed? • Overview • Quasi Public agency that oversees the U.S. banking system. • For the most part, independent of Executive and Legislative branches. • See reading #66 • 7 of the governing members (Governors) at the Fed are Presidential Appointments with Senate Confirmation (like Supreme Court Justices). • Has its own budget • 12 member governing board – the 7 above members plus 5 rotating members from the Federal reserve branch banks (privately owned). • See Supplemental Notes 8 for more detail

Notes on Central Banks • The Central Bank is The Banks’ Bank. The Central Bank operates a clearinghouse for bank checks. Each member bank has an account with the Central Bank. In the U.S. the deposits that banks have with the Fed are called federal funds. • A closely related term, which is not specific to the U.S., is banks’ reserves(which consist of federal funds plus “vault cash”, or currency in the bank’ s cash machines, teller drawers, and vault). • A check written against private bank A and deposited with private bank B reduces bank A’s federal funds and increases bank B’s federal funds. Thus banks want federal funds so they can honor check withdrawals. They want vault cash to honor cash withdrawals. Upshot: banks need reserves to honor withdrawals. • Neither the Fed nor other major Central Banks target growth rates of the money supply(which consists of currency plus various measures of liquid assets like deposits). • Fed targets the Federal Funds rate.

What is the federal funds rate? • Federal funds are the deposits of private banks with the Fed. • The federal funds market consists of private banks borrowing and lending their federal funds amongst each other overnight. • The federal funds rate is the interest rate on these overnight loans. It is set by supply and demand, not by the Fed. • The Fed can change the supply of federal funds through open market operations, exerting a powerful indirect effect on the fed funds rate. • The Fed targets the federal funds rate and carries out open market operations to keep the actual rate near the target rate.

A Fed purchase of government securities … • Raises the supply of federal funds. More federal fundsmeans they are cheaper to borrow, so a lower federal funds rate. (An increase in the supply of federal funds lowers their “price”); • Drives up the price of those securities, which lowers their yield. A lower yield means a lower interest rate on government securities; • Leaves banks flush with reserves. Banks find it profitable to convert some of their new zero-interest-earning reserves into loans (which in turn creates more deposits, raising the money supply). To get people/firms to borrow more (take the new loans they are offering), banks lower the interest rate on the loans. • Bottom Line: A Fed purchase of government securities lowers i.

Notes on FOMC directives • The Federal Reserve Open Market Committee(FOMC) meets every 6 weeks and issues a directive to the trading desk of the Federal Reserve Bank of New York. • Fed Time: the Desk carries out open market operations between 11:30 and 11:45 ET each trading day to keep the actual fed funds rate near the target. • The FOMC directive is also asymmetric or symmetric: • Symmetric: • No bias. Neutral stance. Just as likely to raise as to lower the target next. • Asymmetric: • A bias toward easing (more likely to lower than raise the target next) or a bias toward tightening (more likely to raise than lower the target next). • The symmetry of the directive is not public until over 6 weeksafter each meeting. • Look at the federal funds rate futuresin the WSJ to see what the market thinks.

Federal Reserve’s Lending • The discount rateis the interest rate on direct loans from the Fed to private banks. The Fed sets the discount rate. • Discount window loans used to play a minor role in Fed policy (primary and secondary credit discount loan since 2003) • With the recent crisis, more banks have used discount windows loans together with new borrowing channels. • New Monetary Policy instryments: Term Auction Facility (TAF), Term Asset-Backed Securities Loan Facility (TALF), Commercial Paper Funding Facilities (CPFF), …

The Fed’s Balance Sheet • The Fed receives interest on its assets (U.S. government securities + loans to banks). • The Fed pays no interest on its liabilities (currency and fed funds). • The Fed is highly profitable, which fosters its independence. The Fed returns its profits to the Treasury. • Hence the interest that the Treasury pays on securities held by the Fed is not a cost for the Government: that portion of public debt is effectively monetized(pays 0 interest)

The Quantity Theory of Money: Quantity Equation • M*V = P*Y • M = money supply, P = the GDP deflator, Y = real GDP • V = velocity = PY/M. We define V in this way • If V is constant and Y is beyond the Central Bank’s LR control then ... • When the Central Bank doubles M, the result is a doubling of P • “Inflation is always and everywhere a monetary phenomenon” • This Friedman quote is not literally correct because of Y and V movements. But a LR correlation of .95 means it’s close enough.

Notes on the Quantity Equation • V is defined so that the Quantity Equation holds. Identity: P = MV / Y . • Inflation (rising P) is caused by too much money chasing too few goods, i.e. by M rising relative to Y (controlling for how much M we need to transact PY, which is V). • Noteinflation could rise despite fixed M because of falling Y or rising V. Across countries, however, most differences in inflation (P growth) are associated with differences in M growth: correlation between M growth and inflation is above .95. • V is not fixed in reality. V rises with financial innovation and with i(the nominal interest rate). Recall that i = r +π. If, like Y, r is beyond the Central Bank’s LR control, then higher inflation translates one-for-one into higher i. Implication: V rises with the rate of inflation. • Thus taking into account that V is not fixed only makes the channel from M growth to P growth stronger: when M growth is high it generates inflation , which raises V, which in turn raises inflation further. This is a big deal in hyperinflations.

Monetizing Government Debt • When public debt is growing faster than GDP, there is political pressure on the Central Bank to monetize some of the government debt b/c • public debt pays interest, reserves do not; • fixed nominal debt is easier to pay off the higher is P. • Large budget deficits are the underlying cause of hyperinflations. The debt and deficit limits in Europe’s EMU are meant to prevent member countries from pushing for higher inflation. • Central Bank independence from fiscal authorities can insulate it from pressure to monetize the public debt. The Central Bank buys public debt with reserves (increases monetary base!).

Why Do Governments Grow the Money Supply? • Short Term Political Gains- reduce unemployment (or raise output). If the economy is capacity constrained - prices must rise (however, this usually occurs with a lag!) • Accommodating Supply Shocks- The U.S. in the 70s! (as opposed to breaking the inflation cycle). • Financing Government Deficitsby Printing Money!!! • We will deal with these reasons more as the course progresses.

Money Demand • Agents decide how much wealth to keep as money: Portfolio allocation decision • 3 main characteristics of assets matter: • Expected Return: The higher the expected return the higher consumption the agent can enjoy! • Risk: Agents are risk-averse, hence to hold a risky asset, it must have a higher expected return • Liquidity: The easier is to exchange the asset for goods, services or other assets, the more attractive is the asset. • Money is highly liquid! • Money is the most liquid BUT has a low return!

Money Demand (continued) • Nominal money demand is proportional to the price level. For example, if prices go up by 10% then individuals need 10% more money for transactions. • As Y increases, desired consumption increases and so individuals need more money for the increased number of desired transactions. This is the liquidity demand for money. • As the nominal interest rate on non-money assets (bonds), i, increases the opportunity cost of holding money increases and so the demand for nominal money balances decreases. • Since i = r + πe, we can decompose the effects on an increase in i into real interest rate increases (holding expected inflation fixed) and expected inflation increases (holding the real interest rate fixed).